The “Double Tax” Problem – Holding Private Company Shares on Death
Private corporations are a commonly used legal structure in the Canadian tax and business landscape. However, they also present unique tax implications with respect to post-mortem tax planning. When creating or revising an individual’s estate plan, it is imperative these tax implications are carefully considered.
The “Double Tax” Problem
As previously discussed in Tax Consequences When A Person Passes Away in Canada, when an individual passes away in Canada, subject to certain deferrals, they are generally deemed to dispose of all their capital assets at fair market value. The deceased’s terminal tax return will be subject to taxes on any accrued capital gains, net of capital losses, resulting from this deemed disposition. Where the individual held private company shares upon their passing, there is a potential double tax that results. Post-mortem tax planning can mitigate this double tax, but often requires planning prior to death.
To illustrate this double tax issue, consider Mr. X, who wholly-owns the shares of a private corporation, Opco. Opco has an estimated fair market value of $5 million and Mr. X’s cost of these shares is nominal. On Mr. X’s passing, he would be deemed to dispose of his Opco shares at their fair market value of $5 million, resulting in estimated taxes payable of $1.34 million (based on the top marginal tax rates in BC). The cost of these shares to the estate would be increased from a nominal amount to $5 million.
If Opco were to subsequently pay a dividend of $5 million to the estate, this dividend would result in taxes of up to $2.44 million (based on the top marginal tax rates in BC). Opco paying dividends, rather than the estate selling Opco shares, occurs where the Opco shares are not saleable or where the beneficiaries intend to retain the Opco business.
In this example, the Opco interest would effectively be taxed twice, once as a capital gain on the deemed disposition of the Opco shares on Mr. X’s passing, and again as a taxable dividend on any dividends paid by Opco to the estate or its beneficiaries. Despite tax being paid on the accrued capital gain on the Opco shares on Mr. X’s passing, the increased cost of the Opco shares does not reduce taxes on future dividends paid by Opco. The result would be total taxes payable of approximately $3.78 million, being an effective tax rate of 75.6% of the value of Opco’s shares.
There are two common post-mortem tax planning strategies to address and mitigate this double tax—pipeline planning and loss carryback planning.
The pipeline strategy utilizes the high cost of the private company shares (i.e., Opco) held by the estate created on the deemed disposition upon death (i.e., $5 million) to extract corporate funds, free of tax at the shareholder level.
This plan generally involves the transfer of the private corporation shares by the estate to a newly incorporated holding company (Newco) in exchange for a promissory note. Subject to certain restrictions, Opco can distribute funds to Newco, then to the estate by way tax-free payments on the promissory note, rather than by way of taxable dividends.
Using the above example, a pipeline plan could allow Opco to distribute $5 million to Mr. X’s estate without incurring additional tax on taxable dividends.
In certain circumstances, the pipeline plan could also allow Opco to increase the cost base of certain non-depreciable capital property (commonly referred to as a “bump”), which could result in further tax deferral on a future sale of Opco’s assets.
The pipeline plan may reduce the overall effective tax rate on private company shares held on death from as high as 75.64% to 26.75% (overall tax savings of 48.89%). This type of planning is nuanced and must be structured carefully to ensure no negative tax consequences result. Further, bump planning requires a change of control to occur as a consequence of death, and thus restructuring prior to death may be necessary to facilitate a post-mortem bump.
The loss carryback plan involves the company redeeming its shares held by the estate, resulting in a deemed dividend and a capital loss that can be carried back to the deceased’s terminal tax return. This type of planning must be completed within the first year of death if the shares are held by a graduated rate estate, or within three years if the shares are held by an alter ego trust or a joint spousal trust.
In our example, Opco could redeem the shares held by Mr. X’s estate within one year of Mr. X’s passing and distribute its corporate assets to the estate in satisfaction of the redemption proceeds. This would result in a taxable deemed dividend to the estate, as well as a capital loss on the shares of Opco. The capital loss can be carried back to Mr. X’s terminal tax return to offset the original capital gain from the deemed disposition of shares on death. This type of planning reduces the overall effective tax rate on private company shares held on passing from as high as 75.6% to up to 48.89% (overall tax savings of 26.75%).
It is important to note that taxable dividends are currently subject to higher personal marginal tax rates than capital gains. Therefore, the overall effective tax rate may be higher under the loss carryback strategy when compared to the pipeline strategy.
Similar to pipeline planning, the loss carryback strategy is complex and requires careful planning to ensure the intended tax results are obtained.
When formulating an estate plan prior to death, it is critical that post-mortem planning be considered in respect of an individual’s assets and that the estate plan remains flexible to allow for tax-efficient post-mortem planning. The optimal post-mortem plan will depend on various non-tax factors, such as plans to continue the Opco business vs. a sale of Opco, timing of Opco funds needed, the types of assets held by Opco, as well as family dynamics of the beneficiaries of the estate.
Reach out to one of Smythe’s estate planning experts today to discuss how to effectively structure your estate plan.